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AS AN ECONOMIST SPECIALIZING IN JAPAN, Richard Jerram arrived in Tokyo in 1987, at the time of the Great Bubble. There, with a timeout for a Ph.D. from the London School of Economics, he watched the country go through its long decline and recent revival. We phoned Jerram in Tokyo at Macquarie Securities to catch up on what the July 29 Upper House rout means for Prime Minister Shinzo Abe and for global investors, and whether Japan, sometimes viewed as a haven, really is one. For Jerram's views, read on.

Barron's: Could you brief us on the July 29 election? What are the implications?

Jerram: The government did very poorly. It no longer has a majority in the Upper House, so it's going to be very hard for it to get things done. Technically, they can bludgeon bills though the Upper House because they've got a two-thirds majority in the Lower House. But clearly you don't want to bully the Upper House into pushing bills through too frequently. If the government spends critical capital, it won't be in economic areas, it's going to be in things more related to international relations or possibly domestic educational policies. It seems a reasonably good bet that just about nothing will happen on the economic front over the next couple of years.

What had people expected?

My view was that the Abe administration had no interest in economics. But there was an argument that once this election was out of the way, you'd see the real reformist coming out of Abe, which always seemed far-fetched to me. Whereas in Japan, it's been very, very difficult to sell reform, in the last couple of years. there's a growing sense of concern about inequality. The low probability of reform just got smaller. To push up support for the next election in a couple of years, the [ruling Liberal Democrat Party] needs to push up its traditional rural support base, which implies continued agricultural protection or increased rural spending -- more bridges to nowhere. So for the short term, possibly nothing happens or something that's not very positive.

How about the longer term?

It does seem the public, after putting up with 15 years of dreadful policy management, is starting to express some dissatisfaction. Look at the economy -- the crisis is over and there are more jobs than people looking for jobs. The banks are solid. Deflation is pretty much over. Land prices have stopped falling. Despite that, the government took a hammering in the polls. If you do get a general election in the next couple of years, you actually have a reasonable chance of the LDP losing power. People assume the opposition is such a rainbow coalition that it will fall before the next election, and if the opposition does manage to stick together, then they can easily win. It's still the same problem: There's not a great enthusiasm for pro-market reform, and the central opinion is a social-democrat type of reform. But policies will be very fluid because of the broad spectrum of opinion. So it could get really interesting.

Meaning woes for investors?

Interesting, meaning unpredictable. But they haven't had to give serious thought yet to their policy positions because they've been condemned to permanent opposition.

What does the market want to see?

Top of the list is tax reform. Around 70% of companies never pay tax, and this isn't because they are unprofitable, it's because they exploit loopholes. The ability to operate without any tax liability encourages inefficiencies. The second area is deregulation. There's always been progress, but the rest of the world is turning fairly fast, and even though Japan is reforming, it makes comparisons with the past rather than the rest of the world. But disposing of government assets would be an obvious place to start.

What happened to privatization of the postal system, which is like a gigantic bank? It was the rallying theme for the [ex-Premier Junichiro] Koizumi government in the snap election two years ago?

It was important for its symbolism rather than its actual impact. It would be better for the economy if they simply closed some parts of the organization down than privatized them. You risk setting up an institution with implicit government guarantees and subsidies competing with the private sector. But the reform is happening; it will be another 10 years before it's fully implemented. It's probably not good for some of the regional banks, which will face tough competition, but they have time to adapt.

Let's turn to the economy. What's happening with deflation, the consumer?

People don't appreciate the dynamism of this economy. The policy failures of the 1990s created so many distortions that once the roots of the problem -- the distressed banking system and deflation -- are resolved, you have a productivity catch-up and unavoidable efficiency gains, which is what you're seeing. The corporate sector is gradually more enthusiastic. The frustration with this domestic reflation, or normalization, is it's creaking to life with an extreme amount of caution after 10 years of misery.

Things are getting better. The consumer can get a job, his wages are going up, he is prepared to spend a little more. You are getting such good productivity gains from the better resource allocation that, unfortunately, the recovery is not generating inflationary pressure. What you see in real terms is what you get in nominal terms. Consumption is growing 1% to 2% real. If you could stick a couple of percentage points inflation on that, you get a respectable top line, but right now it's unimpressive.

What does this mean for interest rates? The Bank of Japan recently stayed its hand because of market turbulence.

Interest rates are going to go up. The BOJ is telling us that they will normalize rates almost with disregard to current economic conditions. Inflation has been back in negative territory for the past five months, and the BOJ is still saying, because it has a forward-looking policy, it is comfortable raising rates. There are two basic problems in this. The framework is misguided: The BOJ has a much lower inflation tolerance than most other central banks, and lower than economic theory suggests is sensible. They're unable to predict inflation, because it's hard to figure out how much spare capacity is there. It's difficult to have a forward-looking policy if you don't have confidence to predict what happens next.

So, rates will go higher. By when?

It looks to me like they will raise rates again, probably October, from 0.5% now, after making sure the data are still solid and the world is not melting down. My impression is that [BOJ Governor Toshihiko] Fukui would like to leave office with the rates at 1%, so maybe they'll raise again in March as a farewell gesture. It's less predictable beyond that, because you don't know about the new governor -- whether it will be someone more aggressive or a standard insider. The argument that they will raise rates again in October and March is not really based on an assessment of economic conditions. It's based on an assessment of the guidance being offered by the BOJ.